Microsoft learns to love leverage

September 23, 2010

If you thought the era of better living through financial engineering died with Lehman Brothers, have a look at Microsoft.

The ubiquitous computer software company has decided to borrow as much as $6 billion at the same time as it is increasing its dividend by 23 percent, despite sitting on a $36.8 billion cash hoard and generating more every day.

It reminds me of the old Saturday Night Live skit about the “Bank of Change,” which existed only to turn dollars into quarters and pennies into dimes. “How do we do it?” their pitchman said, “Volume.”

Microsoft’s shares fell more than 2.5 percent on the news, but mostly because investors had hoped for a bigger return of cash, presumably financed by a bigger bond issue.

It looks as if Microsoft will pay out about $5.6 billion annually in dividends, quite close to the size of the bond issue and perhaps a quarter of the free cash the company is likely to generate in fiscal 2011.

So why would Microsoft want to borrow money when it already has so much and is shoveling more in every day? Partly no doubt because financial conditions engineered by the Federal Reserve have made borrowing so cheap for the world’s few remaining AAA credits. According to initial indications Microsoft will pay anywhere between 30 and 87.5 basis points over Treasuries for borrowings of between three and 30 years.

Could it be that Microsoft thinks it can make money by funding and reinvesting? A hedge fund and a software company — there’s a business model for you.

There may be more here than an arbitrage between Microsoft’s future and financial conditions, though. A Bloomberg story quoted an unnamed source as saying the debt issue was partly so that Microsoft could avoid repatriating to the United States cash held abroad, in essence to avoid taxation.

All of this is fine and well: Microsoft is responding to market demand; for dividends from equity investors and for safe yields from bond buyers, and they may be at the same time, legally of course, shafting the public coffers, an old and venerable sport.

What niggles is that this is emblematic of a very long-running trend which has now engulfed even Microsoft, of companies increasingly engaging in financial engineering and tax arbitrage when perhaps greater sustainable profits could be generated through product development. In other words, of increasing financialization of the economy.

This has led corporations in aggregate to become, despite what company accounts will tell you, more highly leveraged and more vulnerable.

CORPORATE LEVERAGE HIGH

In fact, corporate leverage, as measured using the Federal Reserve Flow of Funds report, is at an all-time high, according to economist Andrew Smithers, of Smithers & Co in London.

Corporate debt has more than doubled relative to GDP since 1952, standing now at about 50 percent, according to the data. Smithers argues that, as the ratio of capital to output has remained stable but the proportion of GDP produced by corporations has fallen the rise in debt implies rising leverage.

Compared to 1997, U.S. corporations are using about 20 percent more debt to produce the same dollar of profit, and this figure is before you consider the uncounted amount of off-balance-sheet debt corporations are responsible for. According to a PricewaterhouseCoopers survey, proposed accounting changes would increase by 58 percent the amount of interest-bearing debt the average corporation shows on its published balance sheets.

“The prevalent misinformation about corporate leverage has important implications for the stock market,” Smithers wrote in a report to clients.

“So long as the current myth survives, it will probably help to support share prices and encourage corporate M&A activity, providing it can be financed. It makes the market, however, more than usually vulnerable to better information, particularly if improved understanding comes with falling profits.”

And, as debt has risen, so has the ratio of cash payouts, returns of cash to shareholders either in the form of dividends or share buybacks, which now stands at about 125 percent of domestic profits after tax.

It seems to me that U.S. companies have, like their middle-class customers, made up in the past decade for a lack of core profit generating ability through leverage.

Like the middle class, for a time that has flattered their results and made it appear that they could sustain a higher level of production or consumption than was actually possible.

Shareholders had better hope profits stay at this level, or the whiplash from high leverage could be severe. As for the economy, this implies that we’d better stop waiting for the fabled mountain of corporate cash to be invested. Like the mountain of investor cash in money market accounts, it must first be compared to the even bigger mountain of debt.

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